Board of Governors of the Federal Reserve System

Federal Deposit Insurance Corporation

Office of the Comptroller of the Currency

Interagency Guidance on Funds Transfer Pricing

Related to Funding and Contingent Liquidity Risks

March 1, 2016

The Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance
Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) are issuing this
guidance on funds transfer pricing (FTP) practices related to funding risk (including interest rate
and liquidity components) and contingent liquidity risk at large financial institutions (hereafter
referred to as “firms”) to address weaknesses observed in some firms’ FTP practices.[F otne1 The
guidance builds on the principles of sound liquidity risk management described in the
“Interagency Policy Statement on Funding and Liquidity Risk Management,” 2[F otne and incorporates
elements of the international statement issued by the Basel Committee on Banking Supervision
titled “Principles for Sound Liquidity Risk Management and Supervision.” [F otne3

Background

For purposes of this guidance, FTP refers to a process performed by a firm’s central management
function that allocates costs and benefits associated with funding and contingent liquidity risks
(FTP costs and benefits), as measured at transaction or trade inception, to a firm’s business lines,
products, and activities. While this guidance specifically addresses FTP practices related to
funding and contingent liquidity risks, firms may incorporate other risks in their overall FTP
frameworks.

FTP is an important tool for managing a firm’s balance sheet structure and measuring risk-
adjusted profitability. By allocating funding and contingent liquidity risks to business lines,
products, and activities within a firm, FTP influences the volume and terms of new business and
ongoing portfolio composition. This process helps align a firm’s funding and contingent
liquidity risk profile and risk appetite and complements, but does not replace, broader liquidity
and interest rate risk management programs (for example, stress testing) that a firm uses to
capture certain risks (for example, basis risk). If done effectively, FTP promotes more resilient,
sustainable business models. FTP is also an important tool for centralizing the management of

- For purposes of this guidance, large financial institutions includes: national banks, federal savings associations and
state-chartered banks with consolidated assets of $250 billion or more, domestic bank and savings and loan holding
companies with consolidated assets of $250 billion or more or foreign exposure of $10 billion or more, and foreign
banking organizations with combined U.S. assets of $250 billion or more.E te1.]
ndofF
- Refer to: FRB’s SR letter 10-6, “Interagency Policy Statement on Funding and Liquidity Risk Management”;
FDIC’s FIL-13-2010, “Funding and Liquidity Risk Management Interagency Guidance”; and OCC Bulletin 2010­
13, “Final Policy Statement: Interagency Policy Statement on Funding and Liquidity Management.”Ete2.]
ndofF
- The Basel Committee on Banking Supervision statement on “Principles for Sound Liquidity Risk Management and
Supervision” (September 2008) is available at http://www.bis.org/publ/bcbs144.htm.E
te3.]
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funding and contingent liquidity risks for all exposures. Through FTP, a firm can transfer these
risks to a central management function that can take advantage of natural offsets, centralized
hedging activities, and a broader view of the firm.

Failure to consistently and effectively apply FTP can misalign the risk-taking incentives of
individual business lines with the firm’s risk appetite, resulting in a misallocation of financial
resources. This misallocation can arise in new business and ongoing portfolio composition
where the business metrics do not reflect risks taken, thereby undermining the business model.
Examples include entering into excessive off-balance sheet commitments and on-balance sheet
asset growth because of mispriced funding and contingent liquidity risks.

The 2008 financial crisis exposed weak risk management practices for allocating liquidity costs
and benefits across business lines. Several firms “acknowledged that if robust FTP practices had
been in place earlier, and if the systems had charged not just for funding but for liquidity risks,
they would not have carried the significant levels of illiquid assets and the significant risks that
were held off-balance sheet that ultimately led to sizable losses.” [F
otne4

Funds Transfer Pricing Principles

A firm should have an FTP framework to support its broader risk management and governance
processes that incorporates the general principles described in this section and is commensurate
with its size, complexity, business activities, and overall risk profile. The framework should
incorporate FTP costs and benefits into product pricing, business metrics, and new product
approval for all material business lines, products, and activities to align risk-taking incentives
with the firm’s risk appetite.

Principle 1: A firm should allocate FTP costs and benefits based on funding risk and contingent
liquidity risk.

A firm should have an FTP framework that allocates costs and benefits based on the following
risks.

• Funding risk, measured as the cost or benefit (including liquidity and interest rate
components) of raising funds to finance ongoing business operations, should be allocated
based on the characteristics of the business lines, products, and activities that give rise to
those costs or benefits (for example, higher costs allocated to assets that will be held over a
longer time horizon and greater benefits allocated to stable sources of funding).

• Contingent liquidity risk, measured as the cost of holding standby liquidity composed of
unencumbered, highly liquid assets, should be allocated to the business lines, products, and
activities that pose risk of contingent funding needs during a stress event (for example,
draws on credit commitments, collateral calls, deposit run-off, and increasing haircuts on
secured funding).

- Senior Supervisors Group report on “Risk Management Lessons from the Global Financial Crisis of 2008”
(October 21, 2009) is available at
https://www.newyorkfed.org/medialibrarv/media/newsevents/news/banking/2009/SSG report.pdf.E te4.]
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Principle 2: A firm should have a consistent and transparent FTP framework for identifying and
allocating FTP costs and benefits on a timely basis and at a sufficiently granular level,
commensurate with the firm ’s size, complexity, business activities, and overall risk profile.

FTP costs and benefits should be allocated based on methodologies that are set forth by a firm’s
FTP framework. The methodologies should be transparent, repeatable, and sufficiently granular
such that they align business decisions with the firm’s desired funding and contingent liquidity
risk appetite. To the extent a firm applies FTP at an aggregated level to similar products and
activities, the firm should include the aggregating criteria in the report on FTP.[F
otne5 Additionally,
the senior management group that oversees FTP should review the basis for the FTP
methodologies. The attachment to this guidance describes illustrative FTP methodologies that a
firm may consider when implementing its FTP framework.6[F otne

A firm should allocate FTP costs and benefits, as measured at transaction or trade inception, to
the appropriate business line, product, or activity. If a firm retains any FTP costs or benefits in a
centrally managed pool pursuant to its FTP framework, it should analyze the implications of
such decisions on business line incentives and the firm’s overall risk profile. The firm
customarily would include its findings in the report on FTP.

The FTP framework should be implemented consistently across the firm to appropriately align
risk-taking incentives. While it is possible to apply different FTP methodologies within a firm
due to, among other things, legal entity type or specific jurisdictional circumstances, a firm
should generally implement the FTP framework in a consistent manner across its corporate
structure to reduce the likelihood of misaligned incentives. If there are implementation
differences across the firm, management should analyze the implications of such differences on
business line incentives and the firm’s overall funding and contingent liquidity risk profile. The
firm customarily would include its findings in the report on FTP.

A firm should allocate, report, and update data on FTP costs and benefits at a frequency that is
appropriate for the business line, product, or activity. Allocating, reporting, and updating of data
should occur more frequently for trading exposures (for example, on a daily basis). Infrequent
allocation, reporting, or updating of data for trading exposures (for example, based on month-end
positions) may not fully capture a firm’s day-to-day funding and contingent liquidity risks. For
example, a firm should monitor the age of its trading exposures, and those held longer than
originally intended should be reassessed and FTP costs and benefits should be reallocated based
on the modified holding period.

A firm’s FTP framework should address derivative activities commensurate with the size and
complexity of those activities. The FTP framework may consider the fair value of current
positions, the rights of rehypothecation for collateral received, and contingent outflows that may
occur during a stress event.

- See Principle 3 for a discussion of the report on FTP.E

te5.]
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- The FRB, the FDIC, and the OCC will monitor evolving FTP practices in the market and may update or add to the
illustrative methodologies in the attachment.E
te6.]
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To avoid a misalignment of risk-taking incentives, a firm should adjust its FTP costs and benefits
as appropriate based on both market-wide and idiosyncratic conditions, such as trapped liquidity,
reserve requirements, regulatory requirements, illiquid currencies, and settlement or clearing
costs. These idiosyncratic conditions should be contemplated in the FTP framework, and the
firm customarily would include a discussion of the implications in the report on FTP.

Principle 3: A firm should have a robust governance structure for FTP, including the
production o f a report on FTP and oversight from a senior management group and central
management function.

A firm should have a senior management group that oversees FTP, which should include a broad
range of stakeholders, such as representatives from the firm’s asset-liability committee (if
separate from the senior management group), the treasury function, and business line and risk
management functions. This group should develop the policy underlying the FTP framework,
which should identify assumptions, responsibilities, procedures, and authorities for FTP. The
policy should be reviewed and updated on a regular basis or when the firm’s asset-liability
structure or scope of activities undergoes a material change. Further, senior management with
oversight responsibility for FTP should periodically, but no less frequently than quarterly, review
the report on FTP to ensure that the established FTP framework is being properly implemented.

A firm should also establish a central management function tasked with implementing the FTP
framework. The central management function should have visibility over the entire firm’s on-
and off-balance sheet exposures. Among its responsibilities, the central management function
should regularly produce and analyze a report on FTP generated from accurate and reliable
management information systems. The report on FTP should be at a sufficiently granular level
to enable the senior management group and central management function to effectively monitor
the FTP framework (for example, at the business line, product, or activity level, as appropriate).
Among other items, all material approvals, such as those related to any exception to the FTP
framework, including the reason for the exception, would customarily be documented in the
report on FTP. The report on FTP may be standalone or included within a broader risk
management report.

Independent risk and control functions and internal audit should provide oversight of the FTP
process and assess the report on FTP, which should be reviewed as appropriate to reflect
changing business and financial market conditions and to maintain the appropriate alignment of
incentives. Lastly, consistent with existing supervisory guidance on model risk management,[F otne7
models used in FTP implementation should be independently validated and regularly reviewed to
ensure that the models continue to perform as expected, that all assumptions remain appropriate,
and that limitations are understood and appropriately mitigated.

Principle 4: A firm should align business incentives with risk management and strategic
objectives by incorporating FTP costs and benefits into product pricing, business metrics, and
new product approval.

- Refer to: FRB’s SR letter 11-7, “Guidance on Model Risk Management”; OCC Bulletin 2011-12, “Supervisory
Guidance on Model Risk Management.”ndofF
te7.]E
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Through its FTP framework, a firm should incorporate FTP costs and benefits into product
pricing, business metrics, and new product approval for all material business lines, products, and
activities (both on- and off-balance sheet). The framework, the report on FTP, and any
associated management information systems should be designed to provide decision makers
sufficient and timely information about FTP costs and benefits so that risk-taking incentives
align with the firm’s strategic objectives.

The information may be either at the transaction level or, if the transactions have homogenous
funding and contingent liquidity risk characteristics, at an aggregated level. In deciding whether
to allocate FTP costs and benefits at the transaction or aggregated level, firms should consider
advantages and disadvantages of both approaches when developing the FTP framework.
Although transaction-level FTP allocations may add complexity and involve higher
implementation and maintenance costs, such allocations may provide a more accurate measure of
risk-adjusted profitability. A firm assigning FTP allocations at an aggregated level should have
aggregation criteria based on funding and contingent liquidity risk characteristics that are
transparent.

There should be ongoing dialogue between the business lines and the central function
responsible for allocating FTP costs and benefits to ensure that funding and contingent liquidity
risks are being captured and are well-understood for product pricing, business metrics, and new
product approval. The business lines should understand the rationale for the FTP costs and
benefits, and the central function should understand the funding and contingent liquidity risks
implicated by the business lines’ transactions. Decisions by senior management to incentivize
certain behaviors through FTP costs and benefits customarily would be documented and included
in the report on FTP.

Conclusion

A firm should use the principles laid out in this guidance to develop, implement, and maintain an
effective FTP framework. In doing so, a firm’s risk-taking incentives should better align with its
risk management and strategic objectives. The framework should be adequately tailored to a
firm’s size, complexity, business activities, and overall risk profile.

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 Attachment
Illustrative Funds Transfer Pricing Methodologies

March 1, 2016

The Funds Transfer Pricing (FTP) methodologies described below are intended for illustrative
purposes only and provide examples for addressing principles set forth in the guidance. A firm’s
FTP framework should be commensurate with its size, complexity, business activities, and
overall risk profile. In designing its FTP framework, a firm may utilize other methodologies that
are consistent with the principles set forth in the guidance. Therefore, these illustrative
methodologies should not be interpreted as directives for implementing any particular FTP
methodology.

Non-Trading Exposures

For non-trading exposures, a firm’s FTP methodology may vary based on its business activities
and specific exposures. For example, certain firms may have higher concentrations of exposures
that have less predictable time horizons, such as non-maturity loans and non-maturity deposits.

Matched-Maturity Marginal Cost o f Funding

Matched-maturity marginal cost of funding is a commonly used methodology for non-trading

exposures. Under this methodology, FTP costs and benefits are based on a firm’s market cost of
funds across the term structure (for example, wholesale long-term debt curve adjusted based on
the composition of the firm’s alternate sources of funding such as Federal Home Loan Bank
advances and customer deposits). This methodology incentivizes business lines to generate
stable funding (for example, core deposits) by crediting them the benefit or premium associated
with such funding. It also ensures that business lines are appropriately charged the cost of
funding for the life of longer-dated assets (for example, a five-year commercial loan). Given that
funding costs can change over time, the market cost of funds across the term structure should be
derived from reliable and readily available data sources and be well understood by FTP users.

FTP rates should, as closely as possible, match the characteristics of the transaction or the
aggregated transactions to which they are applied. In determining the appropriate point on the
derived FTP curve for a transaction or pool of transactions, a firm could consider a variety of
characteristics, including the holding period, cash flow, re-pricing, prepayments, and expected
life of the transaction or pool. For example, for a five-year commercial loan that has a rate that
resets every three months and will be held to maturity, the interest rate component of the funding
risk could be based on a three-month horizon for determining the FTP cost, and the liquidity
component of the funding risk could be based on a five-year horizon for determining the FTP
cost. Thus, the total FTP cost for holding the five-year commercial loan would be the
combination of these two components.

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Contingent Liquidity Risk

A firm may calculate the FTP cost related to non-trading exposure contingent liquidity risk using
models based on behavioral assumptions. For example, charges for contingent commitments
could be based on their modeled likelihood of drawdown, considering customer drawdown
history, credit quality, and other factors; whereas, credits applied to deposits could be based on
volatility and modeled behavioral maturity. A firm should document and include all modeling
analyses and assumptions in the report on FTP. If behavioral assumptions used in a firm’s FTP
framework do not align with behavioral assumptions used in its internal stress test for similar
types of non-trading exposures, the firm should document and include in the report on FTP these
inconsistencies.

Trading Exposures

For trading exposures, a firm could consider a variety of factors, including the type of funding
source (for example, secured or unsecured), the market liquidity of the exposure (for example,
the size of the haircut relative to the overall exposure), the holding period of the position, the
prevailing market conditions, and any potential impact the chosen approach could have on firm
incentives and overall risk profile. If a firm’s trading activities are not material, its FTP
framework may require a less complex methodology for trading exposures. The following FTP
methodologies have been observed for allocating FTP costs for trading exposures.

Weighted Average Cost o f Debt (WACD)

WACD is the weighted average cost of outstanding firm debt, usually expressed as a spread over
an index. Some firms’ practices apply this rate to the amount of an asset expected to be funded
unsecured (repurchase agreement market haircuts may be used to delineate between the amount
being funded secured and the amount being funded unsecured). A firm using WACD should
analyze whether the methodology misaligns risk-taking incentives and document such analyses
in the report on FTP.

Marginal Cost o f Funding

Marginal cost of funding sets the FTP costs at the appropriate incremental borrowing rate of a
firm. Some firms’ practices apply a marginal secured borrowing rate to the amount of an asset
expected to be funded secured and a marginal unsecured borrowing rate to the amount of an asset
expected to be funded unsecured (repurchase agreement market haircuts may be used to
delineate between the amount being funded secured and the amount being funded unsecured). A
firm using marginal cost of funding should analyze whether the methodology misaligns risk­
taking incentives, considering current market rates compared to historical rates, and document
such analyses in the report on FTP.

Contingent Liquidity Risk

A firm may calculate the FTP costs related to contingent liquidity risk from trading exposures by
considering the unencumbered liquid assets that are held to cover the potential for widening

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haircuts of trading exposures that are funded secured. If haircuts used in a firm’s FTP
framework do not align with haircuts used in its internal stress test for similar types of trading
exposures, the firm should document and include in the report on FTP these inconsistencies.
Haircuts should be updated at a frequency that is appropriate for a firm’s trading activities and
market conditions.

A firm may also include the FTP costs related to contingent liquidity risk from potential
derivative outflows in stressed market conditions, which may be due to, for example, credit
rating downgrades, additional termination rights, or market shocks and volatility.

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